Average Rate of Return vs. Actual Rate of Return
My favorite quote from Will Rogers is this:
It isn't what we don't know that gives us trouble; it's what we know that ain't so. Will Rogers 1879-1935
Or said another way…
…”the problem in America isn’t so much what people don’t know, it’s what they think they know that just ain’t so”. Paraphrased by R. Nelson Nash
You see ole Will Rogers knew something about misinformation even back in the 20’s and 30’s.
When I first entered the financial services arena back in January 1998, I was taught by one of the biggest and best life insurance Companies, how to use the “Average Rate of Return” to sell Mutual Funds and Variable Life Insurance contracts and Variable annuities.
The reason why I was taught this is because the “Average Rate of Return” is always higher than the “Actual Rate of Return”. And everyone wants the most they can get when it comes to investing.
Please understand these terms and what they really illustrate.
The “Average Rate of Return” is based on the interest rates in an investment.
The “Actual Rate of Return” is based on the actual dollars in an investment.
Now I ask you this…
What do you use to pay for the items when you make a purchase?
Interest Rates or Dollars?
The next time some Financial Genius is in front of you making his pitch for the next great investment, ask him to show you the “Actual Rate of Return” of the investment.
I’ll bet he cannot or will not show this.
OK, I tell you as your Financial Guru/advisor that I have an investment that has a 25% average rate of return over the past 4 years.
I like that number so you invest $100,000 into this investment expecting your money to grow to somewhere around $244,000 over the next 4-years; if it can duplicate the 25% return that was shown to you.
Here is what the numbers look like, but exaggerated:
Year 1 + 100% gain = my account is at $200,000.
Year 2 -50% loss = my account is at $100,000.
Year 3 + 100% gain = my account is at $200,000.
Year 4 -50% loss = my account is at $100,000.
At the end of year 4, your account has the same amount you started with: $100,000.
You cry out…my average rate of return is ZERO!
But it’s not zero…it is 25% as promised.
The Formula for figuring the Avg. Rate of Return is:
Ending value/balance divided by number of years invested.
$100,000 /4 years = 25% rate of return
The Investment professional delivered as promised.
So what happened to the money that you thought he were getting?
Your earnings are zero and your “Actual Rate of Return” is zero.
You should have asked to see the “Actual rate of return”; not the Average Rate of Return.
So you can see that Will Rogers was right when he made his insightful comment about the problem of what we think we know that ain’t so.
This is one of the biggest problems in the financial services arena today…being able to discern “Misinformation” from “Truthful” information.
I hope this helps you as you continue your educational journey.
Stay tuned for another of Joe’s Teaching Moments.